Stock Exchanges In India

Stock Exchanges are an organized marketplace, either corporation or mutual

organization, where members of the organization gather to trade company
stocks and other securities. The members may act either as agents for their
customers, or as principals for their own accounts.

Stock exchanges also facilitate for the issue and redemption of securities and
other financial instruments including the payment of income and dividends.
The record keeping is central but trade is linked to such physical place
because modern markets are computerized. The trade on an exchange is only
by members and stock broker do have a seat on the exchange.

List of Stock Exchanges In India

» Bombay Stock Exchange
» National Stock Exchange
» Regional Stock Exchanges
» Ahmedabad
» Bangalore
» Bhubaneshwar
» Calcutta
» Cochin
» Coimbatore
» Delhi
» Guwahati
» Hyderabad
» Jaipur
» Ludhiana
» Madhya Pradesh
» Madras
» Magadh
» Mangalore
» Meerut
» OTC Exchange Of India
» Pune
» Saurashtra Kutch
» UttarPradesh
» Vadodara
Introduction
Stock markets refer to a market place where investors can buy and sell
stocks. The price at which each buying and selling transaction takes is
determined by the market forces (i.e. demand and supply for a particular
stock).

Let us take an example for a better understanding of how market forces

determine stock prices. ABC Co. Ltd. enjoys high investor confidence and
there is an anticipation of an upward movement in its stock price. More and
more people would want to buy this stock (i.e. high demand) and very few
people will want to sell this stock at current market price (i.e. less supply).
Therefore, buyers will have to bid a higher price for this stock to match the
ask price from the seller which will increase the stock price of ABC Co. Ltd.
On the contrary, if there are more sellers than buyers (i.e. high supply and
low demand) for the stock of ABC Co. Ltd. in the market, its price will fall
down.

In earlier times, buyers and sellers used to assemble at stock exchanges to

make a transaction but now with the dawn of IT, most of the operations are
done electronically and the stock markets have become almost paperless.
Now investors dont have to gather at the Exchanges, and can trade freely
from their home or office over the phone or through Internet.

History of the Indian Stock Market - The Origin

One of the oldest stock markets in Asia, the Indian Stock Markets have a
200 years old history.

18th East India Company was the dominant institution and by end
Century of the century, busuness in its loan securities gained full
momentum
1830's Business on corporate stocks and shares in Bank and Cotton
presses started in Bombay. Trading list by the end of 1839 got
broader
1840's Recognition from banks and merchants to about half a dozen
brokers
1850's Rapid development of commercial enterprise saw brokerage
business attracting more people into the business
1860's The number of brokers increased to 60
1860-61 The American Civil War broke out which caused a stoppage
 of cotton supply from United States of America; marking the
beginning of the "Share Mania" in India
1862-63 The number of brokers increased to about 200 to 250
1865 A disastrous slump began at the end of the American Civil
War (as an example, Bank of Bombay Share which had
touched Rs. 2850 could only be sold at Rs. 87)

Pre-Independance Scenario - Establishment of Different Stock

Exchanges

1874 With the rapidly developing share trading business, brokers used
to gather at a street (now well known as "Dalal Street") for the
purpose of transacting business.
1875 "The Native Share and Stock Brokers' Association" (also known
as "The Bombay Stock Exchange") was established in Bombay
1880's Development of cotton mills industry and set up of many others
1894 Establishment of "The Ahmedabad Share and Stock Brokers'
Association"
1880 - Sharp increase in share prices of jute industries in 1870's was
90's followed by a boom in tea stocks and coal
1908 "The Calcutta Stock Exchange Association" was formed
1920 Madras witnessed boom and business at "The Madras Stock
Exchange" was transacted with 100 brokers.
1923 When recession followed, number of brokers came down to 3
and the Exchange was closed down
1934 Establishment of the Lahore Stock Exchange
1936 Merger of the Lahoe Stock Exchange with the Punjab Stock
Exchange
1937 Re-organisation and set up of the Madras Stock Exchange
Limited (Pvt.) Limited led by improvement in stock market
activities in South India with establishment of new textile mills
and plantation companies
1940 Uttar Pradesh Stock Exchange Limited and Nagpur Stock
Exchange Limited was established
1944 Establishment of "The Hyderabad Stock Exchange Limited"
1947 "Delhi Stock and Share Brokers' Association Limited" and "The
Delhi Stocks and Shares Exchange Limited" were established
and later on merged into "The Delhi Stock Exchange
Association Limited"

Post Independance Scenario

The depression witnessed after the Independance led to closure of a lot of
exchanges in the country. Lahore Estock Exchange was closed down after
the partition of India, and later on merged with the Delhi Stock Exchange.
Bnagalore Stock Exchange Limited was registered in 1957 and got
recognition only by 1963. Most of the other Exchanges were in a miserable
state till 1957 when they applied for recognition under Securities Contracts
(Regulations) Act, 1956. The Exchanges that were recognized under the Act
were:
1. Bombay
2. Calcutta
3. Madras
4. Ahmedabad
5. Delhi
6. Hyderabad
7. Bangalore

8. Indore
Many more stock exchanges were established during 1980's, namely:
• Cochin Stock Exchange (1980)
• Uttar Pradesh Stock Exchange Association Limited (at Kanpur, 1982)
• Pune Stock Exchange Limited (1982)
• Ludhiana Stock Exchange Association Limited (1983)
• Gauhati Stock Exchange Limited (1984)
• Kanara Stock Exchange Limited (at Mangalore, 1985)
• Magadh Stock Exchange Association (at Patna, 1986)
• Jaipur Stock Exchange Limited (1989)
• Bhubaneswar Stock Exchange Association Limited (1989)
• Saurashtra Kutch Stock Exchange Limited (at Rajkot, 1989)
• Vadodara Stock Exchange Limited (at Baroda, 1990)
• Coimbatore Stock Exchange

• Meerut Stock Exchange

At present, there are twenty one recognized stock exchanges in India which
does not include the Over The Counter Exchange of India Limited (OTCEI)
and the National Stock Exchange of India Limited (NSEIL).

INDIAN STOCK EXCHANGES

Stock Exchanges are structured marketplace where affiliates of the union

gather to sell firm's shares and other securities. India Stock Exchanges can
either be a conglomerate/ firm or mutual group. The affiliates act as
intermediaries to their patrons or as key players for their own accounts.

Stock Exchanges in India also assist the issue and release of securities and
other monetary tools incorporating the fortification of revenues and
dividends. The book keeping of the trade is centralized but the buying and
selling is associated to a particular place as advanced marketplaces are
mechanized. The buying and selling on an exchange is only open to its
affiliates and brokers.

Dfferent stock exchanges in India

(a) National Stock Exchange (NSE) of India

Integrated in November 1992, the National Stock Exchange of India (NSE)

was initially a tariff forfeiting association. In 1993, the exchange was
certified under Securities Contracts (Regulation) Act, 1956 and in June 1994
it started its business functioning in the Wholesale Debt Market (WDM).
The Equities division of NSE began its operations in 1994 while in 2000 the
corporation incorporated its Derivatives division.

In order to lift the Indian stock market trading system on par with the
international standards. On the basis of the recommendations of high
powered Pherwani Committee, the National Stock Exchange was
incorporated in 1992 by Industrial Development Bank of India, Industrial
Credit and Investment Corporation of India, Industrial Finance Corporation
of India, all Insurance Corporations, selected commercial banks and others.

NSE provides exposure to investors in two types of markets, namely:

1. Wholesale debt market
2. Capital market
 Wholesale Debt Market - Similar to money market operations, debt
market operations involve institutional investors and corporate bodies
entering into transactions of high value in financial instrumets like
treasury bills, government securities, commercial papers etc.

Trading at NSE

• Fully automated screen-based trading mechanism

• Strictly follows the principle of an order-driven market
• Trading members are linked through a communication network
• This network allows them to execute trade from their offices
• The prices at which the buyer and seller are willing to transact
will appear on the screen
• When the prices match the transaction will be completed

•A confirmation slip will be printed at the office of the trading

member
Advantages of trading at NSE
• Integrated network for trading in stock market of India
• Fully automated screen based system that provides higher degree
of transparency
• Investors can transact from any part of the country at uniform
prices

• Greater functional efficiency supported by totally computerized

network

Some NSE Figures and Facts

• The equities division of NSE covers around 300 Indian cities, while
its derivates section covers 305 cities.
• The number of securities accessible for buying and selling in NSE
exchange in its equities and derivates section are 1,383 and 3,143
respectively.
• The total amount of Settlement warranty fund in NSE equities
division and derivates section are Rs 2,085.25 crores and Rs 6,018.30
crores respectively.
 • The daily turnover of NSE equities division is Rs 10,336.52 crores,
for derivates segment is Rs 32,809.96 crores and for Whole sale debt
division is Rs 13,911.57 crores.
• NSE uses satellite communication expertise to strengthen
contribution from around 400 Indian cities.
• The exchange administers around rs 1 million of buying and selling
on daily basis.
• It is one of the biggest VSAT incorporated stock exchange across
the world.
• Currently more than 8,500 customers are doing online exchange
business on NSE application.

(b) Bombay Stock Exchange (BSE) of India

The oldest stock market in Asia, BSE stands for Bombay Stock Exchange
and was initially known as "The Native Share & Stock Brokers
Association." Incorporated in the 1875, BSE became the first exchange in
India to be certified by the administration. It attained a permanent
authorization from the Indian government in 1956 under Securities Contracts
(Regulation) Act, 1956.

Over the year, the exchange company has played an essential part in the
expansion of Indian investment market. At present the association is
functioning as corporatised body integrated under the stipulations of the
Companies Act, 1956.

Some BSE Figures and Facts

• BSE exchange was the first in India to launch Equity Derivatives,

Free Float Index, USD adaptation of BSE Sensex and Exchange
facilitated Internet buying and selling policy
• BSE exchange was the first in India to acquire the ISO
authorization for supervision, clearance & Settlement
• BSE exchange was the first in India to have launched private
service for economic training
• Its On-Line Trading System has been felicitated by the
internationally renowned standard of Information Security
Management System.
(c) Regional Stock Exchanges (RSE) of India

The Regional Stock Exchanges in India started spreading its business

operation from 1894. The first RSE to start its functioning in India was
Ahmedabad Stock Exchange (ASE) followed by Calcutta Stock Exchange
(CSE) in 1908.

The stock exchange in India witnessed a flourishing phase in 1980s with the
incorporation of many exchanges under it. In early 60s, it has only few
certifies RSEs under it namely Hyderabad Stock Exchange, Indore Stock
Exchange, Madras Stock Exchange, Calcutta Stock Exchange and Delhi
Stock Exchange. The recent to join the list was Meerut Stock Exchange and
Coimbatore Stock Exchange.

Catalog of Regional Stock Exchanges in India

• Ahmedabad Stock Exchange

• Bangalore Stock Exchange
• Bhubaneshwar Stock Exchange
• Calcutta Stock Exchange
• Cochin Stock Exchange
• Coimbatore Stock Exchange
• Delhi Stock Exchange
• Guwahati Stock Exchange
• Hyderabad Stock Exchange
• Jaipur Stock Exchange
• Ludhiana Stock Exchange
• Madhya Pradesh Stock Exchange
• Madras Stock Exchange
• Magadh Stock Exchange
• Mangalore Stock Exchange
• Meerut Stock Exchange
• OTC Exchange Of India
• Pune Stock Exchange
• Saurashtra Kutch Stock Exchange
• Uttar Pradesh Stock Exchange
• Vadodara Stock Exchange
Over The Counter Exchange of India (OTCEI)
Traditionally, trading in Stock Exchanges in India followed a conventional
style where people used to gather at the Exchange and bids and offers were
made by open outcry.

This age-old trading mechanism in the Indian stock markets used to create
many functional inefficiencies. Lack of liquidity and transparency, long
settlement periods and benami transactions are a few examples that
adversely affected investors. In order to overcome these inefficiencies,
OTCEI was incorporated in 1990 under the Companies Act 1956. OTCEI is
the first screen based nationwide stock exchange in India created by Unit
Trust of India, Industrial Credit and Investment Corporation of India,
Industrial Development Bank of India, SBI Capital Markets, Industrial
Finance Corporation of India, General Insurance Corporation and its
subsidiaries and CanBank Financial Services.

Advantages of OTCEI

• Greater liquidity and lesser risk of intermediary charges due to widely

spread trading mechanism across India
• The screen-based scripless trading ensures transparency and accuracy
of prices
• Faster settlement and transfer process as compared to other exchange
• Shorter allotment procedure (in case of a new issue) than other
exchanges

TERM LOAN AND PROJECT APPRAISAL

Q: Explain various steps involved for tern loan sanctioning?

Ans: Procedure followed by All-India Financial Institutions and State
Level Financial Institutions.
1) Idea Generation and Financial Projections: Conceiving the
project and preparation of the projections regarding the project.
2) Submission of Loan Application: Submission of loan application
along with project report giving comprehensive information about
project.
3) Initial Processing (Flash Report): Initial processing of loan
application and preparation of “Flash report”.
4) Detailed Appraisal: Appraisal of the proposed project report
covers marketing, technical, financial, managerial and economic
aspects which is prepared after site inspection.
5) Issue of (In –Principal) Letter of sanction: Issue of letter of
sanction i.e.; of financial letter of sanction.
6) Acceptance of Terms and Conditions: Acceptance of the Terms
and Conditions and compliance of the Terms of sanction by the
borrowing unit at its board meeting and passing of resolution of
and conveying its acceptance within a stipulated period.
7) Execution of Loan Agreement: Executions of loan agreement and
payment of Registration charges. The draft loan agreement sent for
execution by authorized persons and to be properly stamped as per
the Indian Stamp Act, 1899 and then the financial institution also
signs it.
8) Disbursement of Funds: disbursement of loans time to time as per
the progress of the projects and the financial status of the project.
9) Creation and Registration of Security: creation of security
through the first mortgage of immovable properties and
hypothecation of moveable properties. Creation of mortgage within
one year from the date of first disbursement failing which 1%
additional interest to be paid. This time limit is given for acquiring
the assets which might be indigenously purchased or assembled or
imported as the case maybe.
10) Monitoring/Post disbursement check: Monitoring done at the
implementation stage as well as the operational stage. Also
monitoring recovery of dues on interest and principle of repayment.

(Q) What are the contents of a Project Report?

Ans: Contents of Project Report:
A project report must contain the following things:
(1) Company Information:
a) Name of the company.
b) Address of the company.
c) Name of the promoter(s).
d) Site and Location.
e) Address of the plants and other facilities.
(2)Proposed Projects Information:
a) Brief history of the proposed project.
b) Objectives of the proposed project.
c) Scope of the proposed project.
(3) Market and Marketing Information:
a) Size of the market for new product.
b) Level of competition.
c) Present demand and supply position.
d) Future growth prospects.
e) Availability of Distribution channel intermediaries –
wholesalers and Retailers.
f) Decision regards 4-P’s of marketing mix.
(4) Technical Information:
a) Technical specifications of the product.
b) Type of raw materials required.
c) Sources of supply of raw materials- whether indigenous or
required to be imported.
d) Details of manufacturing processes- Labour Intensive or Capital
intensive.
e) Plant and Machinery, tools and equipments required.
f) Requirements of land and building including total land area,
built-up area and rent, if any, in case of rental facilities.
g) Location of the plant.
h) Layout of the plant.
(5) Financial Information:
a) Total estimated cost of the project.
b) Cost of capital expenditure as well as working capital
requirements.

c) Contingencies provided for escalation in the cost and

expenses.
d) Preliminary expenses.
e) Sources of finance- long term and short term.
f) Sources of working capital.
 g) Cost of production.
h) Profits and profitability details.
i) Break-even point.
j) Term loans required for the project.
k) Special government incentives, if any.
l) Depreciation on fixed assets.
m) Estimated life of fixed assets.
(6) Manpower Information:
a) Number of personnel required giving a break-up of skilled,
semi-skilled and unskilled
personnel.
b) Salary and wage structure.
c) Training and Development facilities.
d) Staff quarters and other facilities required.
e) Government regulation in relation to employment and wage
payment.

(Q) What is Flash Report?

Ans: The bank prepares a flash report. This flash report is to gauge
whether it is feasible to provide the loan to the applicant. It determines
the amount of money that the bank will earn by providing the loan, after
how many years will it be paid back etc.
Financial ratios for appraisal of term loans:
(1)Debt Equity Ratio.
(2)Current Ratio.
(3)Debt Service Coverage Ratio.
(4)Profitability Ratio.
(5)Interest Coverage Ratio.

CASE STUDY

(Q1). Mr. Chawathe, general manager of FICOM, a financial institution,

was in relaxed mood. Just thought of having a walk around, went out, and
grabbed peanuts to munch. As he was about to throw the wrapping paper
in dustbin, he noticed something! The paper was part of an old flash
report of FICOM’s appraisal process. Only partial data was visible. GM
could make out that this was the report of Chemexperts Ltd of Nasik, a
manufacturer of bulk drugs and whose directors were IIt Gold Medalist.
Total Loan sanctioned was Rs.1, 200 Lakh @13% rate of interest on
reducing balance, against the total cost of the project at Rs.1, 850 Lacs.
Principal amount to be repaid in 24 equal quarterly installments. Loan
sanctioned against the security of plant and machinery, collateral security
of RBI Bonds and Personal Guarantee of the directors. You are required
to list any eight items of flash reports.

Solutions:
Name of the Term Lending Financial Institution : FICOM.
Name of the Borrower :
Chemeexperts Ltd.
Set up at : Nasik.
Nature and Type of Business : Manufacturer
of bulk drugs.
Loan amount : Rs.1, 200
lakhs.
Tenure of loan : 6 years.

(I) Market Appraisal:

(1)Manufacturing of bulk drugs which has a huge demand.
(II) Technical Appraisal:
(1)Directors are IIt Gold Medalist therefore they have the required
engineering know how.
(2)The site and location is at Nasik.
(III)Financial Appraisal:
(1) Total cost of the project is Rs.1, 850 lakhs.
(2) Amount of term loan is Rs.1, 200 lakhs.
(3) Promoters are contributing Rs.650 lakhs [Capital cost Rs.1, 850
lakhs – Rs.1, 200 lakhs] as margin money towards the project.
(4) Security for term loan:
(a) Primary security of Plant and Machinery.
(b)Collateral security of RBI Bonds and
(c) Personal guarantee of the Directors.
(5) Promoters are contributing 35.14% (approx.) of the total project
cost.
(6) The Debt-Equity Ratio after the proposed term loan will be
 1.85:1.
(7) Amount of Term Loan Rs.1, 200 lakhs.
(8) Rate of interest @ 13% on RBM.
(9)Principal amount repayment in 24 equal quarterly installments
(IV) Economic Appraisal:
(1)Manufacturing of bulk drugs resulting into positive impact
on health in the society.
(V)Managerial Appraisal:
(1)Directors are IIt Gold Medalist.
(2)Directors have technical expertise due to higher professional
qualifications.

(Q2). You are approached by a Financial Institution to appraise the

following project:
Name of the Borrower: Blue Lines Chemicals Private Limited.
Proposed loan is taken to set up a technical chemical unit for processing
industrial waste into a marketable product XYZ. The product has a
demand for Rs.50, 000 Litres. The processing costs include variable cost
of Rs.5 per Litre and a fixed cost 9excluding depreciation0 Rs.30, 000
per year. Advertising expenses are also expected to be Rs.20, 000 per
year.
XYZ can be sold at Rs.10 per Litre. Raw Material (Industrial Waste) is
available at re.1 per Litre.
The Capital Cost of Chemical Unit is Rs.7, 50,000.
The company has applied for a loan of Rs.6, 00,000 for a term of 10
years that is over the life of the asset. The promoters of this company are
young, dynamic and highly qualified people but are doing the venture for
the first time.
The Promoters are unable to provide any collateral security for the loan
except Personal Guarantee of their parents.
They have thought of this project after market research. The said research
has stated in the risk factors about invasion of South Korea in Chemical
Market and drastic reduction in Selling Price of similar products.
The above unit is SSI unit and its average tax rate is 20%.
Interest Rate is 12% p.a.
Loan is repayable equally in 10 annual installments along with interest at
the end of each year.
You are required to:
(1)Give the Cash Flow generated by the above project for the first 3
years only.
(2)Calculate the Debt Service Coverage Ratio for the above 3 years.
(3)Prepare Flash Report presenting the above information to the
Financial Institution.

Solution:
(1)Facts:
Name of the Borrower: Blue Lines Chemicals Private Limited.
Proposed Loan : Rs.6, 00,000
Tenure of Loan : 10 years.
Purpose : To set up a chemical unit for processing
industrial waste into a marketable product
“XYZ”.
(I) Market Appraisal:
(1)Promoters have taken up this project after a proper
market research.
(2)The market research report in its risk factors has stated
about invasion of South Korea in chemical market.
(3)The market research report in its risk factors also
mentioned drastic reduction in selling price of similar
products.
(II) Technical Appraisal:
(1)The project involves setting up of a waste recycling
plant.
(III) Financial Appraisal:
(1)Promoters are contributing as margin money Rs.1,
50,000 [Capital Cost 7, 50,000-6, 00,000 loan amount].
(2)Promoters are unable to provide any collateral security
for the loan except personal guarantee of their parents.
(3)The unit is a Small Scale Industrial (SSI) unit and
therefore it enjoys a lower tax rate of 20% along with
other government incentives.
(IV) Economic Appraisal:
(1)The project involves making proper resource
utilization in the nation.
(2) The projects will results into reduction of waste and
recycling it into usable product.
(V) Managerial Appraisal:
 (1)Promoters are young, dynamic and highly qualified
people.
(2)Promoters are doing the venture for the first time.

(2)Observation and Analysis:

Rs. p.a.
Projected sales 50,000 litres x Rs.10 per litre 5,00,000
Less: Variable Costs:
Processing Costs:
Variable Cost Rs.5 litre x 50,000 litres 2,50,000
Raw Material (Industrial Waste) Re.1 per 50,000
litre x 50,000 litres
Less: Fixed Cost
Fixed Cost (Excluding Depreciation) 30,000
Advertising Expenses 20,000
Profit Before Depreciation, Interest and Tax 1,50,000
Less: Depreciation 7,50,00/10 years 75,000
Profit Before Interest and Tax 75,000

Years
(Rs.)
1 2 3 Total
Calculation of Interest:
Loan outstanding at the beginning 6,00,000 5,40,000 4,80,000 N.A.
Less: Repayment in 10 annual 60,000 60,000 60,000 1,80,000
installments 4,80,000 4,20,000 N.A.
Loan outstanding at the end 5,40,000 64,800 57,600 1,94,000
Interest @12%p.a. on loan at 72,000
beginning 75,000 75,000 2,25,000
Calculation of Cash Flows: 75,000 64,800 57,600 1,94,000
PBIT 72,000
Less: Interest 3,000 10,200 17,400 30,600
Profit Before tax 600 2,040 3,480 6,120
Less: Tax @20% 2,400 8,160 13,920 24,480
Profit After Tax
Calculation of Debt Service
Coverage Ratio: 2,400 8,160 13,920 24,480
Profit After Tax 75,000 75,000 75,000 2,25,000
Add: Depreciation 72.000 64,800 57,600 1,94,400
Interest 1,49,000 1,47,960 1,46,520 4,43,880
Funds Available for
Repayment(A) 60,000 60,000 60,000 1,80,000
Repayments 72,000 64,000 57,600 1,94,000
Loan Repayment 1,32,000 1,24,800 1,17,000 3,74,000
Interest Payment 1.13 1.19 1.25 1.19
Total Loan and Interest
Repayments(B)
Debt Service Coverage Ratio=(A/B)

ECONOMIC VALUE ADDED (EVA)

(Q) Evaluate different Financial Management Objectives.

Ans: Clear objectives are required for wise decision making. Objectives
provide a framework for optimum financial decision – making. In other
words they are concerned with designing a method of operating y6he
internal investment and financing of a firm. There are alternative
approaches in financial literature regarding objectives. Two of the most
widely discussed approaches are:
(1)Profit maximization approach
(2)Wealth maximization approach
(1) Profit maximization decision criterion: Under this approach,
actions that increase profits should be undertaken and those that
decrease profits are to be avoided. In specific operational terms,
the profit maximizations criterion implies that the investment,
financing and dividend policy decisions of firm should be oriented
towards the maximization of profits.

Advantages:
(a) Profit is a test of economic efficiency. It provides the yardstick by
which economic performance can be judged.
(b) It leads to efficient allocation of resources as resources tend to be
directed to uses, which in terms of profitability are the most
desirable.
(c) It ensures maximum social welfare. This is so because the quest for
value drives scarce resources to their most productive uses an d
their most efficient uses.

Limitations:
(a) Lots of confusion.
(b) Time factor not considered.
(c) Avoidance of risk factors.
(d) Avoid capital expenditure.

(2) Wealth maximization decision criterion: This is also known as

value maximization or net present worth maximization. The focus
of financial management is on the value to the owners or suppliers
of equity capital. The wealth of the owner is reflected in the
market value of the shares. So wealth maximization implies the
maximization of the market price of the shares. It has been
universally accepted as an appropriate operational decision
criterion for financial management decisions as it removes the
 technical limitations, which characterize the earlier profit
maximization criterion.

Advantages:
(a) It is a long-term strategy which emphasis on raising the present
value of the owner’s investment in a company and the
implementation of projects that will increase the market value of
the firm’s securities.
(b) Recognizes the risk or uncertainty.
(c) Recognizes the timing of returns by taking into account the trade-
off between the various returns and the associated levels of risk.
(d) Considers the shareholders return by taking into account the
payment of dividend to shareholders.

(Q) What is EVA? What is its significance?

Ans: EVA is a performance metric that calculates the creation of
shareholders value. It distinguishes itself from traditional financial
performance metrics such as net profit and EPS. EVA is the
calculations of what profits remain after the cost of a company’s
capital both debt and equity- are deducted from operating profit. In
corporate finance, Economic Value Added or EVA is an estimate of
true economic profit after making corrective adjustments to
accounting, including deducting the opportunity of equity capital.
EVA can be measured as Net operating Profit After Taxes (NOPAT)
less the money cost of capital.

Significance of EVA:
The concept of Economic Value Added (EVA) that is gaining
popularity globally was found by the Stern & Stewart Company. EVA
can be used by corporate to measure the financial performance. Many
companies globally seem to have destroyed shareholders wealth over a
period of time and only a few have positively contributed to their
wealth. With the help of Economic Value Added (EVA) which tells
what the institution is doing with investor’s hard earned money and it
also finds out whether companies have been able to create
shareholders wealth. The overriding message is that corporate must
always strive to maximize shareholders value without which their
stocks can never be fancied by the market.
EVA is a mirror reflection of an organization true performance. Both
EVA and ‘residual income’ concepts are based on the principle that a
firm creates wealth for its owners only if it generates surplus over the
cost of the total invested capital.

(Q) What are the pros and cons of EVA as a measure of

performance?
Ans: Pros and Cons of EVA:
The advantages and disadvantages of EVA are listed below:
Pros of EVA:
EVA, economic profit, and other residual income measures are
clearly better than earnings or earnings growth for measuring
performance. Eva also highlights parts of the business that are not
performing up to scratch. If a division is failing to earn a positive
EVA, its management is likely to face some pointed questions about
whether the division’s assets could be better employed elsewhere.
EVA sends a message to managers: Invest if and only if the increase
in earnings is enough to cover the cost of capital. For manager who
are used to tracking earning or growth in earnings, this a relatively
easy message to grasp. Therefore EVFA can be used down deep in the
organization as an incentive compensation system. The use of EVA
implies delegated decision making. EVA makes the cost of capital
visible to operating managers. EVA lets the business managers realize
that even assets have a cost and hence stock won’t be lying idle.

Cons of EVA:
EVA does not involve forecasts of future cash flows and does not
measure present value. Instead, EVA depends on the current level of
earnings. It may, therefore, reward managers who take on projects
with quick paybacks and penalize those who invest in projects with a
long gestation periods. From an economic point of view, the outlays
are an investment, not an expense. If a proposal for a new business
forecasts accounting losses during a startup period, but the proposal
nevertheless shows positive NPV, then the startup losses are really an
investment- cash outlay made to generate larger cash inflows when the
new business hits its strides. In short, EVA and other measures of
residual income depend on accurate measures of economic income and
investment.